The Spain Pain Will Not Wane: Continuing the Contagion Saga

Just over two years ago I warned that Spain posed a significant threat to the EU area economies. This was a very unpopular stance, and since I'm more of a medium to long term strategist and Spain didn't experience any immediate pain, my stance was considered even more morose. Well, luckily, I supplied ample research to paying subscribers who were well prepared for what is now evidently coming down the pike.

Spanish 10-year government bond yields broke above 6 percent for the first time this year on Monday as concerns over the country's ability to keep its finances under control pushed debt markets back into "crisis mode".

Spanish yields were expected to rise further towards the panic-triggering 7 percent level beyond which debt costs are widely seen as unsustainable unless the European Central Bank resumes its bond purchases after a two-month break.

Yields on Germany's benchmark 10-year Bund, viewed as the euro zone's safest debt, hit a record low of 1.628 percent. The previous record was established in November 2011, at the height of the debt crisis before the ECB injected around 1 trillion euros of cheap three-year funds into the banking system.

"We're back in full crisis mode," Rabobank rate strategist Lyn Graham-Taylor said. "It is looking more and more likely that Spain is going to have some form of a bailout. Assuming there is not an (ECB) intervention you would not see a cap on Spanish yields, they would just keep increasing."

The latest blow to Spanish markets followed data on Friday that showed record borrowing by its banks from the ECB. Investors' main fear is that banks parked most of the funds in domestic government debt, making them more vulnerable to sovereign stress.

Spain faces a test of investor confidence this week with an auction of two- and 10-year bonds on Thursday.

Six percent is psychologically important for markets as the pace at which yields rise has accelerated on previous occasions when that level was broken. Beyond 7 percent, Greece, Portugal and Ireland struggled to raise cash in the market and were forced to seek financial aid.

Underlining investor fears, the cost of insuring Spanish debt against default hit a record high of $520,000 a year to buy $10 million of protection.

European officials travel to Washington this week seeking a bigger global war chest to combat the debt crisis as Spain’s government battles to quell renewed market turmoil over its finances.

Three weeks after European leaders unveiled emergency euro- area funding exceeding the symbolic $1 trillion mark, concerns about Spain’s position have ratcheted the nation’s borrowing costs to the highest levels this year. Crisis-fighting resources will dominate talks at the International Monetary Fund’s spring meeting in Washington from April 20-22.

While the U.S. insists that Europe can overcome the crisis using its own financial firepower, euro-area officials say they’ve done enough to trigger additional global assistance. The urgency was underscored last week as Spanish and Italian yields jumped, challenging assumptions among the region’s leaders that the worst of the fallout was behind them.

“After three months that were calmer than expected, the euro crisis is back,” said Holger Schmieding, chief economist at Berenberg Bank in London. “The speed of the recent surge in yields has elements of a renewed market panic.”

Spain’s 10-year bond yield climbed as much as 18 basis points today to 6.16 percent, the highest level since Dec. 1, before retreating to 6.06 percent at 2:45 p.m. in Madrid. That extended a rise of 19 basis points last week. Similar-maturity Italian yields rose 4 basis points to yield 5.56 percent. The 17-nation currency fell 0.2 percent to $1.3048 at 2:49 p.m. in Frankfurt, after sliding below $1.30 for the first time since January.

...The surge in borrowing costs prompted one of Spain’s deputy economy ministers, Jaime Garcia-Legaz, to call on theEuropean Central Bank to resume its direct intervention in the markets.

“They should step up purchases of bonds,” Garcia-Legaz said in an April 13 interview, wading into a debate that has split the ECB. While Executive Board member Benoit Coeure signaled April 11 the ECB may buy up Spanish bonds, his Dutch colleague Klaas Knot said two days later that the ECB is “very far” from reactivating the measure.

Professional subscribers can now actually download the original Spanish Bond Haircut Model that we used to calculate loss scenarios - Spain maturity extension_010610 (The Man's conflicted copy). Despite the fact I was probably the most realistically bearish out of the bunch, things have actually gotten materially worse since this model was constructed two years ago, hence it can use a refresh. Alas, it is still quite useful.

The stress caused by Spain breaking the central bank will bring to full fruition the theory behind our European Banking and Insurance research from the last few quarters. All would do well to remember (and re-read, if need be),

"Six percent is psychologically important for markets as the pace at which yields rise has accelerated on previous occasions when that level was broken. Beyond 7 percent, Greece, Portugal and Ireland struggled to raise cash in the market and were forced to seek financial aid."

Nice recap, Zulu Warrior! Good material, as always. Just remember that promise about the Squid...

7 percent? I somewhat miss that part explaining all the bank exposures to derivatives that trigger when this mark is reached...